European banks: Climbing a wall of worry

Further alleviating pressure is the ECB’s intention to follow the AQR with corrective measures should they be needed, including new equity issuance, re-orientation of funding sources, asset separation and sales – which, while they may dilute the value for some existing shareholders, will in the end recapitalize banks and place them on surer footing.

From a macro perspective, funding pressures in Europe are easing, as evidenced by the narrowing of the spreads between peripheral debt and German bunds (Chart 2). Should this trend continue, it could lead to the rerating of peripheral equities as the cost of capital comes down.

Despite the recent strength and the argument for a continued recovery, European banks are a very risky asset. The overhang of sovereign debt problems and potential legal battles has not gone away. High unemployment still plagues the peripheral southern states, and tepid economic growth still seems the best-case scenario for these nations. But as the European equity markets climb a wall of worry, the laggards (i.e., the banks) stand to benefit the most.

A long position in European banks offers the greatest prospect for outperformance over broader indices, in a continued global bull market. The Euro Stoxx Bank index is tradable as a futures contract on the Eurex.